Volatility and the 6-year Cycle

Volatility tends to run very high during years in which the Kress 6-year cycle
is bottoming. Volatility has indeed been a major factor this year and it has
been years since we've seen it as high this year. As I'll attempt to show you
here, this increased volatility can be ascribed to the influence of the 6-year
cycle which has been "hard down" this year and is due to bottom in later September.

The 6-year cycle tends to have a deflationary impact on financial assets,
especially stocks and real estate. This has been reflected in the weak real
estate market as well as the bear market in stocks this year. The S&P has
been a victim of the 6-year cycle-related volatility as money has rotated from
stocks to commodities and back again throughout the year. The wild merry-go-round
ride that this volatility has inflicted on traders isn't over just yet, though
it should be ending in just a matter of weeks.

Looking back at previous years in which the 6-year cycle has bottomed we see
a similar pattern of abnormally high volatility. For instance, the year 1996
was a 6-year cycle bottom year. Notice in the following chart, which shows
the CBOE Market Volatility Index (VXO), that in 1996 stock market volatility
spiked a reading of 24 or above four times during the year. At the time, this
was considered extremely high volatility.

The next 6-year cycle bottom was in 2002, which was also one of the worst
bear market years for stocks since the 40-year cycle bottom in 1974. It wasn't
only the 6-year cycle that bottomed in late 2002, but also the 4-year and 12-year
cycles. The combined influence of these cycles created a strong downward bias
in the stock market and led to a 40% decline in the S&P 500 from its bull
market high a couple of years earlier.

Volatility in 2002 ran exceptionally high as measured by the Volatility Index.
The VXO spiked from a baseline reading of 20 to a multi-year high of 57 in
July 2002 as the S&P was making its internal low. Market volatility then
fell to about 30 as measured by VXO, then spike one last time to the 50 level
in early October as the 4-year/6-year/12-year cycle made its final bottom.
From there, volatility steadily diminished and fell below 30 in late November.

Investors haven't been exempted in 2008 from the volatility that normally
makes its appearance during 6-year cycle bottom years. While the overall level
of volatility this year hasn't been as high as that of the previous 6-year
cycle bottom in 2002, this year has definitely seen its fair share of volatility
spikes.

The volatility trend this year has run extremely high, which is par for the
course since the 6-year cycle is scheduled to bottom in late September. Already
this year there have been three spikes in market volatility as measured by
the VXO: one in January, one in March and another in July. Each of these spikes
has corresponded with a major low in the S&P 500 index. Notice the pattern
of declining tops in these volatility spikes. This shows that while volatility
is still lively at times as we head closer to the final 6-year cycle low, the
magnitude of the spikes is diminishing. This could be interpreted as a sign
that selling power is losing its conviction; however, there is one important
caveat to this observation. Until the final 6-year cycle bottom is in -- which
is less than six weeks from now -- there can always be a final spike in volatility
that breaks this downward trend and a corresponding move lower in the S&P.
The 6-year cycle bottom still must be reconciled.

The volatility generated by the latest 6-year cycle has inspired a sector
rotation strategy for the hedge funds. As soon as the S&P shows any weakness
the funds run into oil and commodity stocks, but once the S&P reverses
and shows any kind of strength they run back into stocks and abandon commodities.
Although this "sector rotation volatility" is common in years when the 6-year
cycle is bottoming, it has been more severe in 2008 than in previous 6-year
cycle bottom years and can be expected to continue until the 6-year cycle is
completely behind us.

As discussed in my recent article, "Crude oil and the 6-year cycle," the years
in which the 6-year cycle bottoms tends to have a depressing effect on stocks
while at the same time having a lifting effect on oil and other key commodities.
We've seen record oil prices in 2008, no doubt due (at least partly) to the
influence of the 6-year cycle. The run-up in the price of crude and other commodities
during times when the stock market was declining has been exacerbated by the
growing influence of hedge funds, whose flexibility enables them to jump in
and out of major sectors. This has a direct impact on market volatility and
explains the yo-yo effect we've seen in the prices of stocks and commodities
in the past several months. Until the 6-year cycle bottom is finally and fully
behind us, the market will still be vulnerable to this volatility at times.

The good news is that the volatility that has characterized the year 2008
to date should soon be dissipating and a smoother stock market course should
be ahead of us once the 6-year cycle bottoms in late September. Virtually every
week this year has seen at least one of the weekly cycles peaking and/or bottoming
in a continuous succession. With this many cross-currents, it's little wonder
the market has had a difficult time achieving a smooth directional flow. Once
we get past the 6-year bottom, however, volatility should stabilize and become
less of a factor as the cycles finally allow for a relatively smoother, sustainable
rally into 2009 until the 10-year cycle peaks next summer.

Clif Droke is a recognized authority on moving averages and internal
momentum. He is the editor of the Momentum Strategies Report newsletter,
published since 1997. He has also authored numerous books covering the fields
of economics and financial market analysis. His latest book is Mastering
Moving Averages. For more information visit www.clifdroke.com